The lack of counter cyclicality in the Basle II framework has received considerable attention from many other economists and practitioners in recent months. Indeed, except for the emergency actions of the government, there has been little to offer by way of counter cyclicality during the recent crisis.
Jamie Dimon, CEO of JP Morgan has made three specific suggestions for improving counter cyclicality in the bank’s 2008 annual report.
v Loan loss reserves can be estimated based on the estimation of credit losses over the life of the loan portfolio. Banks can increase reserves when losses are low and run down the reserves when losses are high.
v If a bank lends very aggressively, the central bank can either impose higher capital costs or reduce the amount it lends to the bank.
v The process of raising capital must be accelerated during a downturn. Banks should be able to make a rights issue in days rather than weeks.
A complex financial system combined with a buoyant economy is a dangerous combination. In a booming economy, there is tremendous demand for capital. So financial institutions are prepared to take more risk than is warranted. When an economic shock hits the system, optimism gives way to pessimism, leading to a self reinforcing downward spiral. When an external shock occurs, banks realize they do not have enough capital in relation to the risks they have taken. They reduce lending. This in turn triggers off a liquidity crisis. So buffers must be built during the good times to be drawn down during recessions.
Raghuram Rajan mentions that, faith in draconian regulation is strongest at the bottom of the cycle. But that is the time, when there is little need for market participants to be regulated. At the same time the misconception that markets will take care of themselves is most widespread at the top of the cycle. Incidentally, that is the point when there is maximum danger and a compelling case for tightening regulation.
How can regulators inject counter cyclicality in the system? In boom times, the market demands very low levels of capital from banks as the general euphoria makes losses seem remote. Should regulators impose higher capital requirements on banks? But we know from past experience that when regulated financial intermediaries are forced to hold more costly capital than the market requires, they try to shift activity to unregulated intermediaries. Even if regulations are strengthened to detect and prevent this shift in activity, banks can always find loopholes that get around capital requirements. At the same time, during a downturn, risk-averse banks will hold much more capital than regulators require. No amount of prodding will bring back the credit expansion that is critical for an economy in a serious recession.
In short, it is not so simple to deal with the cyclicality inherent in the current regulatory framework. Rajan argues new regulations should be comprehensive, contingent, and cost effective.
Regulations should be comprehensive so that they are less likely to encourage the drift of activities from heavily regulated to lightly regulated institutions over the boom. Regulations should also be contingent. They must have the maximum impact when the danger to the system is most potent. This will make regulations more cost effective, and less prone to arbitrage or dilution. For example, instead of raising permanent capital, banks can be asked to arrange contingent capital for troubled times. These “contingent capital” arrangements will be contracted in good times. So they will be relatively cheap compared with raising new capital in a crisis and thus easier to enforce. Because the capital infusion occurs in bad times when capital is really needed, it protects the system and the taxpayer at the right time. Post crisis measures like bailouts can be avoided.
Rather than depending on their discretion, banks could be asked to issue debt that would automatically convert to equity when two conditions are met: first, when the system is in crisis, and second, when the bank’s capital ratio falls below a certain value.
Calomiris adds that “Contingent capital certificates” (CCC)—debts that convert to equity when banks suffer sufficient portfolio losses— may be better than straight subordinated debt for this purpose. CCC are likely to work better than subordinated debt as a source of information about risk and a form of market discipline.
Whatever be the method chosen, there is no doubt, as Rajan mentions that the idea of infusing counter cyclicality in the regulatory framework can no longer be postponed. During a crisis, the temptation on the part of regulators will be to over regulate. Once the recovery takes hold, deregulation will begin and add so much economic value that the deregulatory camp will be strongly empowered. Eventually, though, the deregulatory momentum will gather momentum and eliminate regulatory muscle rather than fat. That is, some of the important checks and balances will go away. Instead of swinging wildly between too much and too little regulation, cycle proof regulation might be a better approach.
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